Description

Freshpet – Short Write-Up

We are short shares of FRPT. The summary of our thesis is laid out below, and our detailed thesis is laid out on subsequent pages.

Highlights

• Freshpet makes refrigerated pet food. The company installs refrigerators at grocery stores, pet stores, and mass merchants. It stocks these company-owned refrigerators with its fresh pet food. The company services and maintains its network of 13,000 refrigerators through 3^rd parties

• The company is on track to generate ~85M of revenue in 2014 and is trading at a ~600M TEV, representing ~7x 2014E sales. It has been unprofitable since inception in 2006. It generated over 80M of operating losses between 2011 and 2013. It burned over 70M of cash between 2012 and 2013

• The short case on FreshPet is simple

  • The company is already ~54% penetrated in its base case TAM for fridge distribution, against which the most productive locations have already most likely been penetrated

  • In order to hit management guidance the company will need to see a meaningful positive inflection in its LFL sales while dealing with cannibalization

  • Given the history of losses, management’s EBITDA margin guidance of 20%+ by 2016 appears very aggressive

  • The company continues to burn cash

  • The product itself is difficult to use and expensive – once the package is opened, it only lasts for a week in the fridge and our checks suggest that it stinks up the refrigerator…contrary to management claims, our checks also suggest that if used on its own, it costs over 2-3x more per feeding than traditional options

• The S-1 either leaves out or does not explicitly state unit economics or same store sales which is very unusual for a company with this type of business model. The company is also using aggressive EBITDA add-backs. We view these as subtle signs of business model weakness

• Catalyst: we think the company misses top-line and earnings estimates and continues to deploy capital at relatively unattractive levels

  • Given this is a very recent IPO (2 weeks ago), we also think investors who own this are thinking about FRPT as a high growth CPG name instead of a low ROIC fridge installer

  • We do not believe there is any significant short interest in the stock (yet)…once initial IPO investors realize what they actually own in FRPT, they will likely sell their shares

• The valuation is egregious. This business is not worthy of anything near a 7x revenue multiple… at best this stock is worth $7/sh (2.5x 2015E revenue) and we think $3/sh is a reasonable base case. We see at least ~60-80% downside from current prices

This is a picture of an actual Freshpet roll (which generates almost all of the company’s sales). Once the plastic packaging is open, the pet owner must slice off a chunk of the roll, cut it into pieces, serve it to the dog, then find a way to reseal the sausage-looking roll before putting it into the fridge. We think this makes it hard to store and messy to serve. The generic rolls come in small sizes, requiring the purchase of multiple rolls weekly in order to use Freshpet as the primary source of feed (the need for multiple rolls is even more pronounced for larger dogs).

The roll reminded us of one of America’s favorite processed meats: Bologna

Company and Situation Description:

Freshpet is a CPG company focused on pet food (currently essentially all of the company’s revenue comes from dog food). It is a pioneer in the “fresh pet food” category and is effectively the only player in the refrigerated/fresh food space.

The company faced substantial obstacles to adoption in its efforts to convince retailers to carry fresh pet food. Merchants had little incentive to utilize refrigerator space to stock fresh pet food. Grocers obviously have to separate pet food from human food meaning they cannot simply toss pet food into the human food coolers. Pet specialty chains such as Petco and PETM also did not have any reason to stock coolers in their stores. Therefore, to encourage adoption of fresh foods, FRPT was forced to install coolers at retailer locations on its own dime. As a result, the FRPT model is highly capital intensive, as the company not only has to spend the upfront capital to install a fridge, but also has to bear the ongoing cost of maintenance, replacement, and stock replenishment of the fridge. This model also results in inevitable execution hiccups as refrigerators break down or have other technical difficulties requiring FRPT to send repair crews to retailers and potentially write stock off due to shrinkage. The only fridge related cost that FRPT is not on the hook for is electricity. In most instances, retailers bear the cost of the electric bill associated with the coolers, and we see this as being a risk to the business model going forward as retailers that are seeing weak productivity out of their coolers may opt out of the FRPT program.

The company was formed in 2006 and has expanded its network of refrigerators to over 13,000 retailers. The CEO of the company was the founder and CEO of Meow Mix (which he successfully sold to Del Monte in 2006). During the road show, management capitalized on the strength of the Meow Mix sale as well as the strength of “natural / better-for-you” products (the CEO pointed to GIS/Annie’s deal) in order to drum up interest in the offering. The company also claimed to be the first pure play public pet food company.

The company owns and operates its Pennsylvania-based pet food manufacturing facility (it refers to its manufacturing facilities as its “Freshpet Kitchens”). It utilizes its refrigerated supply chain to connect its Freshpet Kitchens to retail stores across North America. ~75% of the company’s revenue comes from the mass channel (grocers and WMT), with the balance coming from the specialty/natural channel (PETM, Petco, and WFM). The mass channel is currently 40-50% more productive on a revenue per fridge basis than the pet specialty channel.

Freshpet’s lead sponsor is private equity firm MidOcean Partners. MidOcean Partners is the company’s largest shareholder, having owned ~40% of the business prior to the IPO and now owning ~27% of the company pro forma for the IPO. The primary use of the IPO proceeds was to pay off debt. MidOcean first invested in FRPT in early 2011. Kayne Anderson is also a major investor in the company, and finally Tyson Foods (the chicken company) has a small strategic investment in the business (we think Tyson owns around 3-4% of the company’s stock).

MidOcean brought in CEO Richard Thompson when the firm made its investment in 2011 given his experience in getting pet food brands sold to larger strategics. We believe that MidOcean likely shopped FRPT to strategics but that strategics had no interest in the company given its long history of operating losses and weak unit economics. We also believe that Tyson likely also turned down an opportunity to invest in the business as we expect that Tyson likely had a ROFR given its strategic relationship with FRPT. With loans coming due in 2015 and 2016 and continued cash burn, the company opted to pursue an IPO to recapitalize its balance sheet and to finance its future refrigerator expansion.

Detailed Thesis

• Freshpet has consistently generated operating losses despite already having penetrated >50% of its “base case” TAM and ~40% of the “stretch” TAM it laid out during its roadshow (>13,000 fridges out of its base case goal of ~25,000 and out of its “stretch” goal ~35,000 in the United States)…we find this surprising given the company’s claim of a 15-month payback period and believe this speaks to the significant challenge of getting this uniquely capital intensive business model to scale

• The company has generated almost 80M in operating losses since 2011 which is as far back as we could find data (keep in mind it was founded in 2006)

• Our analysis of FRPT’s unit economics suggests (a) that management is overstating the payback period of the fridges, and (b) that the company has already penetrated its most attractive fridge opportunities and is currently deploying fridges into locations that have far less attractive unit economics

• Based on the nature of recent fridge add locations, we think there are early signs that FRPT has already penetrated its most productive location opportunities

• First, we note that the company has been in effectively all Petcos and Petsmart’s since 2012. While one may intuitively expect Petco and Petsmart to be more attractive than mass/grocery for Freshpet given the “premium” feel of FRPT food, we note that the average revenue per fridge at grocery/mass was $6,500 in 2013 versus only $4,165 in the Pet/Natural channel based on the S-1 (grocery had over a 50% revenue productivity premium to Pet Specialty / Natural…we note that this gap narrowed a bit in 1H14 but remained at over 40%)

• In roadshow commentary, management attributed the gap to lower footfall at the pet specialists

• However, we believe that the underlying capital outlays are identical whether FRPT is placing a fridge in a pet specialist or a grocer

• For our unit economics calculations, we used FY13 revenue and SG&A figures, and used average fridge balance for FY13 (average of FY12 and FY13)

• To calculate the capital outlay, we took the capex that FRPT deployed specifically for fridges (the company breaks it out in the S-1) and divided by fridge adds in 2013 (this worked out to ~$5,000)…we then added the $1,000 marketing allowance the company provides to stores for adding a fridge (this can be found in footnote b of p14 of the final S-1 – it was cleverly hidden in an EBITDA “add back”)

• Based on this math, we think the total capital outlay for a fridge (including marketing allowance and installation) is ~$6,000k

• We then attempted to allocate variable SG&A back to the fridge economics…here we note that “outbound freight” is listed ahead of advertising expense in the S-1 for 2013, and advertising expense was $12MM in 2013…we think outbound freight should surely be captured in the unit economics for the fridge (in fact, for many CPG companies, outbound freight is part of cost of goods sold) and given its listing position in the S-1 believe it was likely larger than 12M in FY13

• Finally, after calculating an allocated SG&A per fridge, we then took the most recently reported gross margin from 1H14 (48.7%)

• Then we ran the analysis using the average revenue per fridge in 2013:

• As one can see in the chart above, we think fridges do not break even until Year 5 based on our math…and we note that we are using quite aggressive assumptions

• We are modeling a LFL sales CAGR of 8% and a SG&A CAGR of only 4% (we vary the SG&A growth to reflect maintenance step ups every 3 years)

• In all likelihood, given fridge warranties only last between 1-3 years according to the S-1, we think it is likely that the company will need to deploy new fridges to replace aging or older fridges every few years which would obviously materially change the unit economics and push out breakeven several years

• Our analysis also effectively assumes no cannibalization which we view as highly unlikely given how penetrated the company already is – as it expands its fridge locations, it is likely to see its LFL sales slow (and this has already been occurring – the delta between top line growth and fridge growth has narrowed from ~18% in FY13 to ~10% in 1H14 to only ~8% in 3Q14)

• Our analysis above represents the average across all types of stores…in 1H14, over 40% of new additions (~750) were in the pet specialty channel (and given that FRPT was already fully penetrated at Petco and Petsmart by 2012, we think the additions likely came largely from lower footfall independent pet specialists rather than from Petco or Petsmart – see Exhibit 1)

• Given the weaker productivity of stores in the pet channel but the same operating and capital expense to get a fridge placed in the pet channel, we think the massive growth in the pet channel in 1H14 is a sign that the business is having a harder time finding attractive places to deploy fridges

• Below we display our cut of the unit economics in the pet channel using a similar methodology:

• As one can see, we have a hard time seeing how the unit economics in the pet channel work at all and therefore wonder if FRPT has already seen its best days in terms of quality of points of distribution

• Our analysis (in Exhibit 1) also suggests FRPT faces a “negative mix shift” of sorts as the comp in its pet specialist channel (which we suspect has very weak unit economics) is holding up well in the low-20s, but its comp in the grocery segment (which has better unit economics) has decelerated meaningfully from the mid-teens to the HSD range

• This worsening performance in grocery/mass is consistent with our channel checks in the grocery/mass space which suggest that consumer adoption of the product has been weak due to the high cost of feeding a dog FreshPet (we have heard that it costs >2x more to feed a dog FreshPet than normal dog food), as well as consumer difficulties actually using the product (it has a shelf life of 7 days, has to be stored in the fridge, and apparently stinks up the refrigerator)

• The unit economics are unsurprisingly very sensitive to the revenue per fridge … while the return on fridges for the average store are by no means particularly attractive in our opinion, as FRPT goes into retail locations that have lower foot fall and productivity, we note that that IRR using our methodology above (which we view as very aggressive in terms of top line growth and operating leverage) drops rapidly:

• Management guidance looks rich – the company is calling for over 30% growth despite both fridge growth slowing and LFL sales slowing – so management needs both an acceleration in LFL sales (which is unlikely as the company is likely to see cannibalization as it is already ~54% penetrated) as well as lower ROICs on new fridges (as it has already tapped the most lucrative markets)

• See Exhibit 1 for our estimate of the LFL sales by channel

• In the most recent quarter available (ended 9/30/14), our estimate for LFL sales was ~8% (top line grew 34.7% y/y and fridges grew 26.3% y/y, implying a LFL growth rate of ~8%)...couple this with management’s guidance for ~2,250 fridge additions (on a base of ~13,500 at YE14 this implies ~17% growth from fridges in FY15) and you can only bridge to a ~25% top-line growth rate going forward despite management guiding to a >30% top-line CAGR between now and 2016

• We think the only way management hits its number is if it either (a) deploys fridges into less lucrative locations (which it already appears to be doing and which appears to be value destructive based on our analysis), or (b) spends more on advertising to try and accelerate the comp (which will kill hopes for the 40-50%+ incremental EBITDA margins that the Street is assuming

• We also note that the company is almost certainly going to see meaningful impact from cannibalization in the next few years given how penetrated they already are within their TAM (~40-50% penetrated) which is going to be a material headwind to LFL sales and may even cause some retailers to rip out fridges if they are not making an attractive enough ROI on the space as their neighboring competitors pick up FreshPet fridges (retailers could be dedicating space to other pet foods at higher margins and that do not require an ongoing electricity expense)

• FRPT’s valuation is incredibly stretched and strategic interest in this asset is very unlikely due to the capital intensity of the business, the weak unit economics, the incredibly lofty valuation, and the extremely high likelihood that strategic acquirers already had a look at FRPT and passed, forcing the company to pursue an IPO

• With management playing up its past success in strategic pet food exits and drawing comparisons of FRPT to BNNY, we think that FRPT bulls are likely playing for a strategic take-out

• We see the probability of a strategic take-out at these valuations as being close to zero for multiple reasons

• First, we believe that MidOcean would have likely shopped this asset broadly prior to pursuing an IPO given that a strategic exit would have been a cleaner and faster way for MidOcean to exit its investment (especially given that IPO proceeds were used to pay down debt)

• Tyson also holds a small ownership stake in FRPT and would have likely had some form of ROFR which it clearly did not exercise

• FRPT valuation is off-the-charts high, likely making it the most expensive CPG company in the market on a revenue multiple basis, and furthermore valuing it at two to three times the valuation of pet food companies that were sold in the past few years (and notably, the pet food M&A comps displayed below involved businesses that were actually profitable!)

• We have provided pet food comps below (trailing multiples):

• FRPT is trading at ~7x FY14E revenue, implying a valuation that is 250% higher than the median pet food deal in the past 15 years

• We think the chart below is a helpful way to frame the valuation. We have estimated 2014 average revenue per fridge at $7,058. Even if you assume that LFL sales at FRPT increase 10% a year from 2014 through 2017 (which implies an acceleration in the comp and assumes no impact from cannibalization as they increase distribution points) and that the company hits a 25% EBITDA margin (above the company’s 2016 goal of 20% which already seems like a very stretched goal), assuming they burn through their cash pile (which they will as they roll out fridges), the stock is trading at ~11x 2017 EBITDA. Given the capital intensity of the business (by 2017 we would imagine they will need to replace their existing fleet of fridges), this seems incredibly stretched (we don’t think business would ever be deserving of a double digit EBITDA valuation given the weak FCF generation characteristics):

• Gross margins have limited upside as we believe that retailers are unlikely to accept meaningful price hikes from FRPT going forward for numerous reasons

• Our checks suggest that FRPT gross margins are already quite high for a pet food company, particularly for pet food that is carried in the mass channel

• Our checks also suggest that the retail markup on FreshPet is lower than that of other premium dog food brands (in fact we understand the gap between Freshpet retail margins and other traditional premium food retail margins may be as wide as 10%...according to our research, this is being driven by Target being particularly aggressive in Freshpet pricing forcing other retailers to follow TGT’s lead)

• In the specialty channel there is very little room to take additional price without damaging demand because Freshpet is forced to sell to the specialty channel through a distributor (pet stores can’t house refrigerated goods in inventory because they don’t have refrigerators on site) and therefore Freshpet products in the specialty channel face two levels of mark-up (distributor plus retail mark-up) before reaching consumers

• Retailers bear the cost of electricity associated with Freshpet refrigerators and are therefore unlikely to be as willing to negotiate on price increases with Freshpet (in fact, they may even negotiate gross margins down)

• Management indicated that awareness for Freshpet among consumers is ~20% which it says is low and creates an opportunity, however we view this as a real risk to EBITDA margins because it may mean that the company will need to increase advertising spending in order to enhance awareness, putting management’s target of 20% EBITDA margins in FY16 at risk

• We note that the company has a significant marketing disadvantage against larger pet food companies due to its lack of scale

• Commodity risk and recall risk

• The company has significant commodity price exposure which has resulted in highly volatile gross margins over the past few years

• The company also faces the risk of product recall or its products causing dogs to fall ill…while these are obviously risks at any pet food company, the liabilities associated with these risks would be very difficult for a company of FRPT’s size to deal with…it also has a more complicated manufacturing process involving greater amounts of real chicken meat (~60% of raw materials cost is chicken) which are likely to create operational challenges that are not faced by kibble manufacturers…this creates yet another barrier a potential acquirer

• Perhaps the most notable aspect of the short case is the fact that there is no clear need for Freshpet to exist and there is a clear reason why competitors have not tried to copycat the Freshpet model…ultimately, pet owners that want to feed their pets fresh food have a far more simple and accessible substitute to Freshpet that is likely to be cheaper than using Freshpet foods. That substitute is fresh human food (boiled chicken and carrots) and many highly engaged “pet parents” already feed their dogs human food

• The existence of this very obvious substitute will put a cap on the TAM and on gross margins and make it less likely that FRPT ever sees its gross margins expand into the 50%+ range as it has guided

• We think it is helpful to put this business into context…it has been around since 2006, is currently found in over 13,000 stores across the United States, yet is only on track to generate ~85M of sales in 2014

• We also point out that in the S-1, management notes that FRPT may never generate enough taxable income to use its NOLs…we agree

Financials and Target Price:

• FRPT currently has a TEV of ~600M but given the cash burn rate we think it may be appropriate to leave the cash out of the TEV calculation. In our target price math below, we do leave the cash out.

Our summary financials are provided below:

Given this is a recent IPO, there are no consensus figures available as yet. However, management guided towards >30% top line growth and EBITDA margins of >20% by FY16. Therefore, we think that consensus is likely to settle around $113M of revenue in FY15 with EBITDA of ~15M in FY15. Our FY15 revenue build generously assumes fridge adds of ~2,200 (in-line with management guidance of reaching ~18,000 fridges by FY16) and LFL sales of 11% which only gets us to 27% top-line growth in FY14 (versus consensus that is likely to be well ahead of this figure). We view our model as generous as we are assuming the comp accelerates from the 8-10% range that it has been running at so far in 2014. We also believe that there is high risk that Freshpet (a) misses its FY16 fridge target, or (b) destroys capital through misguided fridge placements into low productivity retailers, or (c) hits the fridge target but sees a significant spike in cannibalization along the way (which again will impair the unit economics), or (d) sees one or more major retail partners rip out Freshpet fridges due to low productivity.

There are many ways to win on the short.

Key risks would be (a) Costco regions picking up Freshpet (we doubt this happens due to Freshpet volumes being far too low to get Costco’s attention as well as due to what we understand is Costco’s reluctance to allow 3^rd party fridges into warehouses), (b) M&A take-out (we already discussed why we see this as unlikely), and (c) pet owners “en masse” switching to fresh food (we think this is incredibly unlikely and note that if this were to happen, better funded CPG companies will clearly emerge as competitors and grocers will likely think of ways to repurpose their existing fridge space to allow larger CPGs such as Mars into their stores).

Our price target math is displayed below. Based on a weighted average target price derived from a blend of M&A valuation and a multiples-approach valuation, we arrive at a target price of $3.20, implying over 80% downside from current levels. We assume all the cash on balance sheet is burned and net out $18M of debt in our calcs.

Exhibit 1: Analysis on Stores Over Time and Productivity Per Channel Over Time

We had store counts as of 2012, 2013, and 9/30/14. We had to estimate 1H13 and 1H14 but used simple averages to arrive at our estimates

Exhibit 2: Penetration by Store

Exhibit 3: Cost of Feeding – “Premium Brand Dry Kibble” versus Freshpet

ASPCA Annual Cost of Feeding a Dog Dry Kibble

Source: https://www.aspca.org/sites/default/files/upload/images/pet_care_costs.pdf

FreshPet Cost Calculated by Us Below

Source: To arrive at our estimates for FRPT costs we utilized http://freshpet.com/our-foods/how-to-feed/

Catalyst

Guide down within first few months of 2015.  Missing profitability expectations.  Fridges potentially getting pulled out of stores.  We think short interest is still very low, so see a near-term catalyst of more investors realizing that this business is capital intensive and should not be trading on a revenue multiple basis.